Knowledge that Transforms

We provide a general framework for analyzing the effects of insider trading on real investment and welfare as well as the consequences of different regulatory policies in a model where all traders are rational expected-utility maximizers and aware of their position in the market. We find that: with costly information acquisition, an “abstain-or-disclose” rule tends to be optimal; with free information acquisition, laissez-faire is better. This suggests enforcing an abstain-or-disclose rule with a high standard of proof for inside information. Our approach also uncovers the pitfalls of welfare analysis in the noise-trader model. JEL classification: D82, G12, G14.